Construction contractors are often targeted for state and local sales and use tax audits. Why is this? What about contractors is so appealing to these taxing jurisdictions? In a whitepaper published by Avalara in 2017, the reasons why states select certain companies for audit were reviewed. The whitepaper detailed the findings of a study conducted in conjunction with Peisner Johnson & Company. The study reviewed information obtained primarily from Texas and California consisting of approximately 64,000 audits spanning over a period of seventeen years. The findings really were not all that surprising.
Avalara outlined five factors that were heavily evaluated by the states when considering a company for audit:
- Past audit history
- Volume of sales a company reports to the state
- Volume of exempt sales claimed
- Ratio of exempt sales to total sales
The first of those criteria, industry, was identified as one of the leading causes of companies being selected for audit. The report outlines two reasons for this. First, certain industries are targeted based on how they operate. For instance, cash-based businesses tend to be scrutinized due to the many ways that cash transactions can go unreported.
The other reason for targeting a certain industry is that history has told these states that companies in certain industries do not always adhere to the law. Noncompliance may not be intentional. There are several reasons why a company may not comply fully with local tax rules. The tax rules for certain industries may be much more complex than others, resulting in those companies being more prone to errors in their reporting and remitting of taxes. Another reason may be that construction companies typically start from the ground up. Early on, these companies may not have the resources to ensure compliance with the various rules they are required to follow. States understand this and will target those industries as they will likely see a return on their investment.
To make things worse, companies operating in multiple states are disadvantaged because construction tax rules tend to vary by jurisdiction much more than with any other industry. One-third of all audits reviewed were aimed at companies that are headquartered outside of the state, so companies operating in multiple states face much more risk. To compound that risk, multi-state contractors must deal with differing city, county, and state tax rates.
Frequent issues faced by construction companies include;
- Failing to register for sales tax
- Failing to file tax returns in states where services were performed
- Claiming a large number of exempt sales without adequate documentation
- Failing to remit use tax on equipment purchases and rentals
So how does a contractor safeguard against the risks associated with noncompliance? Contractors should enlist the services of a qualified sales and use tax expert. A sales and use tax review can mitigate the risks by assisting the contractor in setting up adequate policies and procedures to ensure compliance. The Avalara study found that the average cost of an audit is approximately $114,000, including penalties, fees, and professional counsel. These are costs that can be avoided if the proper steps are taken on the front end.
If you have any interest in speaking with a sales and use tax expert, please feel free to contact Rob directly.